It is no secret that value investing in the U.S. market has been a disappointing strategy for the past decade or more. The S&P 500 Growth Index, for example, has outpaced the Value Index over the latest 10 years with an annual total return of 15.9 per cent compared with 10.5 per cent. The situation is similar but nowhere near as dire in the Canadian stock market, perhaps because we have fewer growth stocks.
The good news for value investors is that 2021 is starting out with a more favourable bias. Sticking with the S&P 500 indexes, Value is up 7.9 per cent for the three months ended Feb. 26, while the Growth index lags with a gain of only 3.6 per cent over the same time frame. So, is this the beginning of a sustained turnaround for the value sector, or just a dead cat bounce?
The current issue of the Financial Analysts Journal (First Quarter, 2021) has a lengthy article on why value stocks have lagged since the financial crisis in 2007. It doesn’t directly address the issue of when value investing will return to favour, but the article’s title, “Reports of Value’s Death May Be Greatly Exaggerated,” provides a hint as to their conclusions. Two of the authors are academics (Campbell Harvey of Duke University and Juhani Linnainmaa of Dartmouth College), two are practitioners (investment strategists Robert Arnott and Vitali Kalesnik of Research Affiliates LLC). Articles in the Journal are peer-reviewed, which also adds credibility to the analysis.
First, the big picture. Over the entire length of the study, July, 1963, through June 2020, value stocks have outperformed growth stocks by an average of three percentage points a year. This means that the value investor is 4.3 times as wealthy as the growth investor over the full period. This is in spite of the fact that over the past 13 and a half years, 2007 through June, 2020, the tables were turned and growth outpaced value by 5.4 percentage points a year.
The situation at June, 2020, placed value stocks as a group at the deepest valuation discount to growth for the entire 57 year history of the study – deeper even than the discount at the height of the dot-com boom in the spring of 2000.
The authors concede that there can be many reasons why value stocks have lagged growth over the recent period. Their initial focus explores the possibility that changes in the economy have made the traditional definition of value, typically low price-to-book, ineffective in capturing the premium. (Their own study ranked stocks in terms of price-to-book value before placing them in the value or growth portfolios, so this is particularly relevant.)
Studies of the value effect started with low price-to-earnings multiples as the screening criterion, but in the early 1990s academic consensus settled on low price-to-book as the leading definition of value. This was probably acceptable when most public companies were involved in the production of physical goods and the transportation services to move them to market. During the course of the 21st century, bricks and mortar have increasingly become a liability for many businesses while intangible assets are the source of enhanced profit margins. If intangible assets are acquired as a result of a takeover, then they appear and are counted on the corporate balance sheet. If they are the result of a sustained research and development program, they are expensed every year and never show up on the balance sheet, thereby understating the true book value of the company.
The study tackles this problem by capitalizing all R&D expenditures and one third of selling, general and administrative (SG&A) expenses on the grounds that they build human capital and brand development. Not surprisingly, this significantly increases the adjusted book values of many growth stocks and makes them candidates for inclusion in the newly formed value portfolios. When value and growth portfolios are created from this updated database, the growth stocks still outperform, but the differential is narrowed from 5.4 percentage points to 3.2 points.
The message here is clear: Even a simple back-of-the-envelope adjustment to recognize the value of intangible assets results in a significant improvement in the selection process for a value investor.
At this point, we can say that the academics have statistically measured what Warren Buffett has learned intuitively: Prudent spending on R&D and SG&A creates a defensive moat, which doesn’t show up on the balance sheet but does enhance profit margins. In any event, it is clear that when value investing enjoys a revival, investors should include some recognition of intangibles before screening candidates for inclusion in their portfolio.
Explanations for the remaining shortfall range from the advent of extremely low interest rates, which particularly favour long duration assets such as growth stocks, to the 2.3-per-cent probability that 13½ years of poor performance could be an extreme “left-tail outlier, or simple bad luck.” If several years of superior portfolio performance may be the result of good luck rather than skill, then the converse is also true: An extended period of poor performance could be owing to bad luck rather than incompetence.
After a 13-year shortfall, the authors are understandably reluctant to forecast the timing of any turnaround in value stocks and do admit it is possible to slip from the deepest valuation discount in the entire 57-year history – the 100th percentile – even further into unexplored territory. Alternatively, even the slightest hint of mean reversion will result in oversized returns to a value strategy. There are no guarantees, but with value strategies as attractively priced as they have ever been in the past 57 years and with interest rates in an uptrend, this is not the time to throw in the towel.
Robert Tattersall, CFA, is co-founder of the Saxon family of mutual funds and the retired chief investment officer of Mackenzie Investments.
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